Initial coin offerings so far have gone through two major phases in their brief lifespan. The initial phase flew under the regulatory radar in an explosion of deals that raised billions of dollars seemingly overnight and without either registering the offerings with the SEC or complying with an exemption from registration. The ICO atmosphere changed drastically when the SEC issued its now famous DAO report in July 2017, which together with subsequent speecheswritten statements and enforcement actions took the position that tokens will generally be considered securities whose offering would need either to be registered with the SEC or qualify for a registration exemption such as Regulation D. That led to a second phase of issuers launching bifurcated ICOs consisting first of a sale of SAFTs to accredited investors under Regulation D, followed by the public sale of fully function tokens that sponsors would argue are not securities.

During the Senate’s February 6, 2018 committee hearing on cryptocurrencies, SEC Chairman Jay Clayton stressed the importance of disclosure for making informed decisions, but warned investors that no ICO had been registered with the SEC yet. That all seemed to change a month later when a group calling itself The Praetorian Group filed with the SEC a registration statement on Form S-1 to publicly offer and sell its cryptocurrency called PAX. With that S-1 filing, might we be entering a third phase of SEC-registered ICOs? For the reasons covered in this post, probably not.

The Registrant

The S-1 registration statement was filed by a company calling itself The Praetorian Group, and describes a dual business plan to be carried out in two phases. In the first phase, Praetorian will operate as a self-styled cryptocurrency real estate investment vehicle, or CREIV, through which it will purchase and upgrade residential and commercial real estate properties in lower income areas in New York, and then fund “outreach programs” to enrich the quality of life for the residents living in those properties. The second phase is projected to begin 12 months after the commencement of the first, and would involve the creation of a digital wallet that will convert cryptocurrencies (e.g., BTC, ETH, LTC, NEO, XLM) into local fiat currency and enable users to earn a reward in the form of PAX tokens for every purchase they make, which they can then spend, hold or sell.

What’s Wrong with this S-1?

The Praetorian S-1 is so deficient from a disclosure standpoint and so sloppy in its drafting that if the SEC bothered to review it, it may set some sort of record for number of comments in a comment letter.

Not to get overly picky, but the sloppiness starts right on the facing page. For starters, the registrant designates “The Praetorian Group” as its “exact name … as specified in its charter”, leaving out the “Inc.” It provides that the approximate date of commencement of the proposed sale to the public is “upon SEC registration as a ‘security’”. Technically, issuers may only proceed with a public offering after their registration statement is declared effective by the SEC. Also, it appears Praetorian may have marked up the facing page from an old S-1 filing, as Praetorian’s facing page form is missing a reference to emerging growth companies (EGCs).

The EGC facing page omission leads me to a more substantive observation, which is that a registrant more serious about its offering would arguably have availed itself of a JOBS Act feature that allows EGCs to submit an S-1 confidentially and undergo an initial review off the EDGAR radar screen. Why not file confidentially and clear up any disclosure and accounting issues before having to file publicly? On that score, it’s entirely possible that Praetorian isn’t even the first ICO to file an S-1, and may have been beaten in a race to the SEC by a confidential EGC filer we don’t even know about yet.

One of the sections in the S-1 that really jumped out at me is a rather bizarre liability disclaimer, which reads as follows:

To the maximum extent permitted by the applicable laws, regulations and rules the Company and/or the Distributor shall not be liable for any indirect, special, incidental, consequential, or other losses of any kind, in tort, contract, tax or otherwise (including but not limited to loss of revenue, income or profits, and loss of use or data), arising out of or in connection with any acceptance of or reliance on this Prospectus or any part thereof by you.”

Talk about an exercise in wishful thinking. Suffice it to say that I have never seen an issuer in a Securities Act registration statement attempt to disclaim liability for losses of any kind resulting from reliance on a prospectus. Federal securities law clearly allows a private plaintiff to recover damages for economic loss sustained as a result of an issuer’s material misstatements, omissions or fraud.

Pretty interesting given that Praetorian actually states that it’s “mindful of the uncertainties associated with the [SEC]’s view as to whether or not an [ICO] would constitute a ‘security’ under applicable federal securities laws” and consequently that they “believe it is more prudent to register the offering with the SEC to avoid any unanticipated regulatory issues”. It’s as if Praetorian is under the view that a registration statement is a notice filing, rather than a disclosure document to be vetted in great detail in a review process involving typically multiple rounds of comments followed by responses and registration statement amendments, and where issuers may not proceed with selling until the SEC is satisfied that all mandated disclosures have been made and accounting and other issues resolved and the SEC has declared the registration statement effective.

Another bizarre aspect of the S-1 is that Praetorian appears to be confused over whom it may sell to, or that it’s forgotten that it has filed a registration statement (which, if declared effective, would allow it to sell to anyone) and is not seeking to sell within the purchaser requirements of a given exemption:

We strongly encourage each “accredited investor” to access the various SEC websites to gain a deeper and more knowledgeable understanding of this new form of digital currency prior to investing in the PAX token.”

Either Praetorian believes it may only sell in the public offering to accredited investors (as is the case in a private offering exemption under Rule 506(c)), or it strangely thinks that only accredited investors (which by definition must have a minimum net worth or annual income) need to be encouraged to inform themselves of the risks associated with ICOs.

Another glaring deficiency is the lack of risk factor disclosure. The only risk included in the section entitled “Risks and Uncertainties” is the risk that it may not be successful in achieving secondary market listings of the PAX token. Otherwise, the section simply consists of a conclusory statement that prospective purchasers of tokens should evaluate all risks and uncertainties associated with the company, the tokens, the token sale and the business plan prior to any purchase of tokens.

Finally, Praetorian’s S-1 omits in totality all of the information required in Part II of S-1. This includes expenses of issuance and distribution, indemnification of directors and officers, recent sales of unregistered securities, exhibits, financial statement schedules and certain required undertakings.

Conclusion

The Praetorian Guard was an elite unit of the Imperial Roman Army whose members served as personal bodyguards to the Roman emperors, sort of like the Roman equivalent of today’s Secret Service that protects the President. Although the ancient Praetorians continued to serve in that capacity for roughly three centuries, they became notable for their intrigue and interference in Roman politics, including overthrowing emperors and proclaiming successors. In the year 312, the Praetorian Guard was disbanded by Constantine the Great. Like its namesake, The Praetorian Group has generated a fair amount of intrigue with its S-1 filing, but I can only imagine that the great examiners of the SEC will take a page out of Constantine’s playbook and disband this Praetorian Group’s S-1 registration statement.

The Wall Street Journal ominously reported on February 28 that the Securities and Exchange Commission recently issued dozens of subpoenas to initial coin offering issuers and their advisors demanding information about the structure of their ICOs. Although the Commission has yet to officially acknowledge them, the subpoenas are consistent with a series of SEC enforcement actions alleging fraud or illegal sale of securities (see, e.g., here and here) and public speeches and statements warning ICO participants about regulatory compliance and promising greater scrutiny and enforcement (see, e.g., here, here and here).  Nevertheless, the enforcement actions and speeches don’t appear to have had much success in slowing down the pace of the ICO market.  Coinschedule reports that ICOs have raised over $3.3 billion in 88 deals already in 2018 through March 16, and is on pace to exceed the estimated $5.6 billion raised in 2017. The latest SEC subpoena campaign coupled with the accelerating pace of deals suggests the Commission believes its message is not resonating in the ICO market.

Although I’m grateful I didn’t find one of the subpoenas in my mailbox, I’m definitely curious about their contents.  Coindesk quotes industry sources who have seen several of the ICO subpoenas as saying that the requested information includes investor lists, emails, marketing materials, organizational structures, amounts raised, location of funds and people involved and their locations. It also cites an anonymous industry lawyer saying that the 25-page subpoena received by his client was “hyper-detailed” and that it asked for “every bit of communication around the token launch.”

So what exactly is the Commission focusing on?  Many naturally believe the Commission is primarily targeting fraud.  But the Journal, Coindesk and others suggest a different focus: Simple Agreements for Future Tokens or SAFTs.

The SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price.  In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

My first observation is that there may be some confusion in the media regarding SAFTs and Federal securities law, with some seeming to suggest that there may be a conflict of opinion about whether the SAFT itself is a security or whether the contract itself is illegal or non-compliant.  I’ve seen statements such as “what will happen to those who invested time and money if SAFTs don’t satisfy securities law?” and “what happens if the SEC comes out and says SAFTs are illegal”? Crowdfund Insider ran a piece with this provocative title: “Bad News: SAFTs May Not Be ‘Compliant’ After All”.

There should be no controversy regarding the SAFT itself (as opposed to the tokens that ultimately get issued). Protocol Labs and Cooley’s SAFT White Paper states in no uncertain terms that the SAFT is a security and must satisfy an exemption from registration, and contemplates compliance with Rule 506(c) under Regulation D.  I haven’t seen or heard anyone suggesting otherwise.  In fact, each SAFT investor is required to represent in the SAFT that it “has no intent to use or consume any or all Tokens on the corresponding blockchain network for the Tokens after Network Launch” and “enters into this security instrument purely to realize profits that accrue from purchasing Tokens at the Discount Price”. Accordingly, there should be no Federal securities law issue with the issuance of the SAFT itself, assuming of course that the issuer complies with Rule 506(c)’s requirements, i.e., disclosure obligations, selling only to accredited investors, using reasonable methods to verify accredited investor status and filing Form D.

The real issue is whether the eventual tokens, assuming they are issued to investors only when the network is created and the tokens fully functional, are necessarily not securities because of their full functionality.  SAFT proponents argue that fully functional tokens fail the “expectation of profits” and/or the “through the efforts of others” prongs of the Howey test, and thus should not be deemed to be securities. The SAFT White Paper analyzes these two prongs of the test from the perspective of the two likely categories of purchasers of tokens: actual token users and investors.  In the case of actual users, their bona fide desire to make direct use of the relevant consumptive aspect of a token on a blockchain-based platform predominates their profit-seeking motives, so arguably they fail the “expectation of profit” prong of Howey.  Investors, on the other hand, clearly expect a profit from resale of the tokens on a secondary market; that profit expectation, however, is usually not predominantly “through the efforts of others” (because management has already brought the tokens to full functionality) but rather from the myriad of factors that cause the price of assets to increase or decrease on an open market.

Opponents of the SAFT approach (see, e.g., Cardozo Blockchain Project’s Not So Fast—Risks Related to the Use of a “SAFT” for Token Sales) reject the concept of a bright-line test, i.e., they reject the notion that the question of whether a utility token will be deemed a security solely turns on whether the token is “fully functional”.  They maintain that courts and the SEC have repeatedly, and unambiguously, stated that the question of whether or not an instrument is a security is not subject to a bright-line test but rather an examination of the facts, circumstances and economic realities of the transaction.  Opponents also assert that the SAFT approach actually runs the risk of increasing regulatory scrutiny of utility token issuers because of the emphasis on the speculative, profit-generating aspects of the utility tokens (e.g., the investor reps referred to above), which could ironically transform an inherently consumptive digital good (the token itself) into an investment contract subject to federal securities laws.  Others have suggested that reliance on the efforts of management doesn’t end with full functionality of the tokens, and that ultimately the success of the network and hence the investment will turn on whether management is successful in overcoming competition.

If anything, the Commission’s subpoena campaign suggests that the SAFT opponents correctly predicted the increased regulatory scrutiny.  And the increased regulatory scrutiny through the subpoena campaign is a stark warning to ICO issuers and counsel that SAFTs may not be completely safe after all.

On July 25, 2017, the SEC’s Division of Enforcement issued a Report of Investigation (the “Report”) that concluded that the tokens issued in an initial coin offering (“ICO”) by a decentralized autonomous organization called “The DAO” were “securities” and that the ICO itself should either have been registered with the SEC under the Securities Act of 1933 or qualified for an exemption therefrom. Importantly, the Report does not conclude that all ICO tokens are securities or that ICOs must either be registered or satisfy the requirements for an exemption from registration. The Report provides important guidance, however, to blockchain startups and other entities seeking to raise capital in the United States through ICOs as to how to structure those offerings from a regulatory standpoint.

Initial Coin Offerings

An initial coin offering is a crowdfunding technique used primarily by blockchain startups in which the issuer sells cryptocurrency tokens or coins that entitle the purchaser to certain rights ranging from access to the issuer’s product or service once it is available (similar to pre-order based non-equity crowdfunding on sites such as Kickstarter or Indiegogo) to a share in the issuer’s profits (similar to equity based crowdfunding). Purchasers also typically have the right to resell their tokens on an online exchange. Purchasers make their contributions in the form of either fiat currency (e.g., U.S. dollars) or, more typically, virtual currency (e.g., bitcoin or ether). The offering and sale of the tokens are made directly to the public using blockchain technology to bypass conventional capital markets intermediaries and regulatory regimes. Advertising and information releases occur on the issuer’s website and on online forums such as Bitcointalk and Reddit.

Looming over the emerging ICO industry is the issue of whether ICOs are offerings of securities. Some issuers have chosen not to take the risk of offering and selling unregistered securities in the United States and have instead offered and sold ICO tokens only to non-U.S. persons. Among the most popular non-U.S. markets are Singapore, one of the first jurisdictions to adopt a regulatory sandbox and other regulatory relief initiatives for fintech companies, and Switzerland, whose “Crypto Valley” is a major center of blockchain startups. Other issuers in the U.S. have attempted to steer clear of possible regulation by limiting rights of token holders to access to products or services upon availability.

The DAO Initial Coin Offering

The DAO was a virtual entity referred to as a decentralized autonomous organization (i.e., not a corporation, LLC or other legal entity) formed to sell virtual tokens to raise capital for future projects, a variation on an investment fund.  DAO token holders would have the right to share in the earnings from the projects and could otherwise monetize their investments in DAO tokens by reselling them in online platforms serving as secondary markets.  The idea behind this virtual organization was to replace traditional corporate governance and decision making with smart contract coding on a blockchain.  But in addition to the automated governance structure, the DAO did have a human component as well in the form of “curators” who maintained ultimate control over which proposals would be submitted to and voted on by token holders and then funded by the DAO. A majority vote of the DAO token holders was required for a project to be funded.

The SEC’s Analysis

Section 5 of the Securities Act requires that every offer and sale of securities in the United States either be registered with the SEC or satisfy the requirements of an exemption from registration.  But are ICO tokens securities?  Under Section 2(a)(1) of the Securities Act, a security includes an “investment contract”, which was determined in the seminal case of SEC v. W.J. Howey Co. to mean an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.   In determining whether an investment contract exists, the investment of “money” need not take the form of cash. Investors in the DAO used ETH to make their investments. The Report makes clear that such investment is the type of contribution of value that can create an investment contract under Howey.

The Report then found that investors who purchased DAO tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise when they contributed ETH to the DAO in exchange for DAO tokens. The DAO’s various promotional materials informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment. The Report also found that investors expected profits to be derived from the managerial efforts of others—specifically, the DAO’s founders and curators. Because the investors did have an ostensible management role – voting on proposed projects — the central issue was whether the efforts of “others” were undeniably significant and essential to the failure or success of the enterprise. In this regard, the Report found that the DAO’s investors relied on the managerial and entrepreneurial efforts of the founders and the DAO’s curators to manage the DAO and put forth project proposals that could generate profits for the investors. The founders of the DAO also held themselves out to investors as experts in Ethereum, the blockchain protocol on which the DAO operated, and told investors that they had selected persons to serve as curators based on their expertise and credentials. Although DAO token holders were afforded voting rights, the SEC determined that such rights did not provide the holders with meaningful control over the enterprise because (1) their ability to vote for contracts was largely “perfunctory” (they could only vote on proposals that had been cleared by the curators); and (2) their pseudonymity and dispersion made it difficult for them to communicate or join together to effect change or exercise meaningful control.

A second major issue weighing on the ICO industry has been whether the online platforms on which ICO tokens are traded need to be registered under the Securities Exchange Act of 1934 as national securities exchanges.   Section 3(a)(1) of the Exchange Act defines an “exchange” as any group or entity that “provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange…”.  Under Exchange Act Rule 3b-16(a), a trading system meets the definition of “exchange” under Section 3(a)(1) if the platform “(1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade”. Alternatively, a platform could operate as an alternative trading system exempted from the definition of “exchange” if it registers as a broker-dealer, files a Form ATS with the SEC to provide notice of its operations and complies with the other requirements of Regulation ATS. The Report concluded that the platforms on which the DAO tokens were traded were exchanges under the foregoing Rule 3b-16(a) criteria, and thus should have been registered, because they provided users with an electronic system that matched orders from multiple parties to buy and sell DAO tokens for execution based on non-discretionary methods.

Key Takeaways

It’s unclear why the SEC determined to issue an investigative report rather than pursue an enforcement action against the DAO, its promoters and the exchanges on which the ICO tokens were traded. The underlying conclusions, however, are not surprising. Virtual currencies such as bitcoin and ether are “value” and ICOs in which purchasers have a reasonable expectation of profit through the efforts of the issuer’s promoters are securities offerings which must either be registered or qualify for an exemption. Giving investors “perfunctory” voting rights on proposals presented by promoters’ agents will not be enough to overcome a presumption that the investors expect a profit through the efforts of others. It’s worth noting that the SEC did not address ICOs of so called “access tokens” in which purchasers are given only a right to future products or services but no opportunity for profit. Such ICOs would need to be structured very carefully to ensure that contributors have no “reasonable expectation of profit”, and it’s unclear whether as a practical matter issuers will be able to raise significant amounts without offering a profit incentive. Finally, the Report puts ICO platforms on notice that electronic systems that match orders from multiple parties to buy and sell tokens based on non-discretionary methods must register either as a national securities exchange or as a broker dealer under Regulation ATS.